When investing money, there are two variables that are critical to selecting the right investment vehicle – the time horizon and risk tolerance. The best way to allocate your money is to think about putting it in different buckets based on your time horizon and how much risk you are willing to take.
The first decision to make is how long you want to keep the money invested. The time horizon can be short-term, mid-term or long-term.
Short-term: Any money that is going to be for emergency funds or for other expenses that will occur in less than three years would be short-term. This could include money set aside to buy a house or vacation fund for example and would be any money that you need at a specific time and you cannot afford to lose.
Mid-term: This bucket includes money that you need to invest with slightly longer time horizon. This will typically include three years to 10 years and might need funds that you need to pay for your child’s education or upgrade your car.
Long-term: Any money that you will not need for at least 10 years, including the money for retirement will fall in long-term bucket.
First you need to determine whether you want the money in short-term, mid-term or long-term and then put your money in the appropriate bucket. Once you determine the need for money and allocate it to appropriate bucket based on time horizon, then you simply allocate it in right investments for that period. For example, if you are 30-year-old and intend to keep your money invested till you are 65 years old, you have a very long-term time horizon. On the other hand, if you are 55 years old, you have a mid-term time horizon for retirement savings.
All investments have inherent risk in them. Well, almost. There are risk free investments such as 10 year T-bonds, but more on that later. For now, lets assume that most of the investments that you will make will involve some risk. The risk of an investment is measured by looking at how volatile that investment’s historical return has been over time. Risk tolerance is your appetite to lose some or all of the money that your originally invested in return for potentially higher returns. The more risk you are willing to take, the more reward (return) you can get. But higher risk also means that your investment will be more volatile and you are more likely to lose part or all of your original investment. Similarly, the lower the risk or volatile you are willing to accept, the lower will be your returns because you sacrifice some return to keep volatility low.
If you are a conservative investor with low risk tolerance, you will have to give up some returns to keep volatility low. You can hold a higher allocation of bonds in their portfolio because bonds offer less volatility. If you are a more aggressive investor and are willing to accept higher risk in order to get potentially higher returns, you can allocate a higher percentage of their investment in stocks, which are more volatile than bonds and offer higher return potential.
How does risk and time horizon determine where to invest money?
Invest for Security in Short Term
Any money that you need for short-term and cannot afford to lose should be kept in instruments that give you principal protection. This includes vehicles such as savings account, money market account, CD, short-term bonds. You will get low rate on return (current rates are about ~1-2% on 3 year CD) but you will at least have your principal protected in case of large market fluctuations.
Invest for Return in the Long Term
If you are saving for long-term such as retirement or other expenses that are at least 10 years away, you should invest that in instruments that provide better return. The fluctuations in the market tend to even out in the long-term and the impact of volatility will not have a huge impact over the long-term. The best way to invest money for long-term is to put it in a combination of index funds that has stocks and bonds in proportion to your risk tolerance. You should start with 401K or IRA account and do maximum contributions that are allowed in these accounts. Then allocate the amount to target date funds or split between stocks and bonds and change the allocations to tilt more towards bonds as you approach retirement.
How do you think about savings and investing? What factors do you consider when selecting investment vehicles for your money? Please feel free to share.